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"Kee" Points with Jim Kee, Ph.D.

Trade

The Federal Reserve

Asset Classes

Sector Rotation

Every so often I prepare some notes for press interviews and distribute them to Kee Points readers. The notes below will sound familiar to many of you, but sometimes a good summary of what’s been talked about is helpful.

Trade

Wealth is created by production and exchange (trade), and of this exchange is fundamental. Wealth can be created by exchange alone as goods (and people and resources) move from lower-valued uses to higher-valued uses. Not so with production; with production, firms, plants, and workers that make sense in a global economy become redundant (not needed) in a local economy. That’s why markets are pretty sensitive to potential trade wars and to nuances in various summits like the G7 meeting of industrialized countries that wrapped up on Saturday in Quebec. The G7 includes the US, Canada, France, Germany, Italy, Japan, and the United Kingdom. The European Union participates but is not technically part of the G7. Russia was in – it was the “G8” – but was suspended over its annexation of Crimea in 2014 (Some G7 members, including President Trump, desire Russia back in). Even today’s summit in Singapore (this morning Singapore time, Monday evening US time) between President Trump and North Korea’s leader Kim Jong Un can be broadly interpreted as important because its emphasis on weapons reduction would ultimately reduce global tensions that impact trade. Ultimately, markets are looking to whether trade agreements are being negotiated to better “level” trade policies between countries by (1) reducing restrictions in countries where they are high (good), or (2) raising restrictions where they are low (bad). So, you can have “bullish” leveling or renegotiating or “bearish” leveling or renegotiating. My sense is that there will be a little of both, but in the end more bullish than bearish developments. I know that sounds optimistic, but I think there is more recognition of mutual interdependence among countries now than there has been in the past.

The Federal Reserve

The Federal Reserve Open Market Committee (FOMC) meets this week (June 12-13) and the Fed is widely expected to raise the target range for the federal funds rate again, which currently stands at 1.75%. That will be the second hike this year, with one or two more expected by the end of the year. When discussing the Fed (which can be emotional), it helps to recognize that the extraordinary asset purchases (coming to be termed “quantitative easing”) that began in 2008 never led to the hyperinflation predicted by many. Also, the end of quantitative easing, which began in 2013 (“tapering” asset purchases) and ended in 2014, never led to the economic/market collapse predicted by many. Key things to keep in mind are that, historically, the economy speeds up while rates are rising, and the maximum negative impact of rate hikes on the economy occurs 12-16 months after the last rate hike. That would mean no Fed-induced recession this year or next. Also, rising short-term rates could flatten the yield curve, since global forces like the “global liquidity glut” (global cash looking for yield) and lower interest rates abroad could limit how high US rates can go. I think this means that the slope of the yield curve is currently less useful for forecasting in the current environment. Quality spreads(difference in yields between low and high-quality bonds) are probably more worth watching, as low-quality bond default rates tend to rise in downturns, so they sell-off, - i.e. their price goes down and their yield goes up. That means a big widening of spreads would be a prerequisite to an economic downturn, and right now spreads are historically low. As a final caveat, the Fed cut rates to zero following the 2008 recession and kept them there for 7 years, which has no historical precedent. That makes judgement at least as important as empirical analysis (number crunching) in the current environment. Consensus estimates are for 10-year US Treasury yields to be north of 3.5% by 2019 (year-end), 1.4% for the Euro area, 2.15% for the UK, and .13% for Japan (Alliance Bernstein).

Asset Classes

There has been a lot of talk lately about small-cap stock indices hitting their all-time highs, while large-caps (e.g. S&amp;P 500) peaked in January and are since below their all-time highs. Some of this is just small-caps bouncing back from stretches of considerable underperformance (e.g. first half of 2017), while some of it is no-doubt driven by trade angst as small-caps (S&amp;P 600) generate about 5% of sales from overseas, versus about 30% for large-caps (S&amp;P 500) according to Credit Suisse. Small caps look a little more expensive than large caps at this point. However, the valuation gap of small cap stocks to large cap stocks is not as wide as the gap between value stocks and growth stocks. That differential ishistorically high, and it is not because value stocks are particularly cheap, but rather growth stocks are historically expensive (Credit Suisse HOLT). That makes me a little more leery of growth stocks than if it were otherwise (i.e. if value stocks being really cheap accounted for the differential). You can’t use valuation metrics to time asset class “rotations,” but historically these large valuation differentials between growth and value tend to get closed by growth stocks materially underperforming value stocks. This tendency for value and growth (and small and large-caps) to take turns, and the inability to time the switch, manifests itself in research showing that in the long-run you are better off owning both rather than trying to get in and out of each asset class. Owning both also leads to less overall portfolio volatility.

Note on Sector Rotation

Can you make money by looking at how asset classes performed during prior periods, of say, Federal Reserve rate hikes? I used to think so, but after 20 years I’m pretty skeptical. Every new rate hike regime makes historical patterns look weaker and weaker. If you talk to anybody who has attempted to build sector or industry “rotation” models they will tell you the same. Part of this is the fact that there just isn’t a lot of historical sector data, so a lot of observed “patterns” might not be legitimate. Each episode is also somewhat unique, with sectors or industries at different stages of valuation or capital spending (for example) in each episode. And perhaps, most importantly, markets learn. Every Wall Street and global research firm in the world runs the same drill going into a series of Fed rate hikes by looking at how different asset classes and sectors behaved during prior hikes. Any real patterns would be and have been (in my opinion) exploited such that betting on different asset classes based upon prior patterns is probably not a great idea. I’ve made that bet with former research colleagues and won during prior rate hike regimes, and given a little, time I’ll report the results for the current rate-hike regime (i.e. "would I have made money by buying assets that did well based upon past rate hike regimes?").

I’d like to also mention that this week’s Barron’s Magazine featured our CEO &amp; Chief Investment Officer, Jeanie Wyatt, CFA, as she was named to the national Top 100 Women Advisors* list. Jeanie was also the highest ranked from Texas. Congratulations, Jeanie!

*The ranking reflects the volume of assets overseen by the advisors and their team, revenues generated for the firms and the quality of the advisors' practices. The scoring system assigns a top score of 100 and rates the rest by comparing them with the top ranked advisor.